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Explain Current Ratio. What does it indicate?
Current Ratio is a liquidity ratio, indicates the backing available to current liabilities in the form of current assets. A higher current ratio indicates that sufficient assets are available with the organization which can be converted in the form of cash without reduction in value, in a short span of item. Higher the ratio better will be the situation. A standard and ideal current ratio is 2:1
Formula to calculate current ratio = Current Assets/ Current Liabilities
What precautions are required to be taken before drawing a conclusion from Current Ratio?
Following precautions are required before drawing a conclusion from current ratio:
- Valuation of current assets and current liabilities should be made on a consistent basis and as per the accepted accounting principles.
- Current assets do not include the inventories which are obsolete or non moving and receivables do not include debts which are outstanding for a very long time and are not provided for which may be almost non recoverable.
- If current ratio is computed on the basis of balance sheet, abnormal purchases of inventories or abnormal creation of receivables towards the end of accounting period should be considered in the right perspective.
- A higher current ratio indicated unnecessarily high investment in current assets in the form of inventories or receivables or both.
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